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6 Financial Rules of Thumb

I wonder how many of you are big readers. You know the type, the ones who can read a book for a week or sift through endless rows of data and advice to help them develop a financial plan that will lead them to happiness.

However, if you’re like most people and don’t have the time (or the inclination) to read a mountain of books, magazines, and websites, then this article is for you. It will list the “ground rules” for financial planning.

1. Method of Saving / Investment:

Pay Yourself First: Aim to set aside at least 10% of your take-home pay

I’m sure you’ve seen this rule before. I first read it in The Richest Man in Babylon. As you’ll find out, paying yourself first is the most important bill you’ll pay each month.

The best way to implement this rule is to make it automatic. 10% of your take-home pay should be deducted from your paycheck and deposited into a separate bank account. If your employer doesn’t allow you to do this, simply set up a transfer between your main account and your “ten percent” account equal to ten percent of your salary.

If you already have a well-funded emergency fund and your short-term goals are funded, you might be able to put all ten percent into a retirement plan. Of course if you put away 10% in your retirement plan, you’ll be contributing pre-tax to more than 10% after-tax.

2. Short Term Loan Method:

The so-called “Bad” debt should not exceed 20% of your income

Short-term debt includes your car and student loans, as well as your credit cards and other types of debt. Basically everything except your mortgage. You must list all your outstanding liabilities and their minimum/monthly payments. Now add the minimum/monthly payment amounts and you come up with a number.

Take this number and divide it by your monthly take-home pay.

If the result is more than 20%, you carry too much revolving credit. Those new to the workforce or recent graduates often have a higher debt-to-income ratio due to their student loans and low-paying entry-level jobs.

Compulsive spenders also have a problem because they spend every dollar they make.

You should aim to put at least 20% of your net pay towards paying off your outstanding debts. If you stop adding to your short-term debt today, you’ll find that you can pay off most of your short-term debt in anywhere from 3-7 years.

3. Housing Cost Method:

You should spend at least 36% of your monthly salary on housing

This rule is mainly for homeowners, but if you’re buying and spending 36% of your monthly income on rent, you either live in NYC or San Francisco and it’s time to find a new place. Either that or find another room.

Why 36%?

Well, banks want to see that the cost of your monthly loan payments, taxes, insurance, and utilities won’t put an undue burden on your finances.

In short, they calculate the cost of living in your home and know that if you exceed 36% for your housing costs, you’ve probably bitten off more than you can eat.

Regardless of what your current percentages are, aim to lower these percentages over time. Just because a bank is willing to lend you 28 percent of your monthly income doesn’t mean you should borrow that much money to buy a house.

The less money you borrow, the faster you can pay it back and the higher your monthly cash flow will be (because you spend less on your mortgage). The less you spend monthly, the more you’ll invest in your future.

4. Method of retirement:

You need to save about 20 times your gross annual income for retirement

There are a bunch of calculators and spreadsheets on the Internet (I have one too) that you can use to figure out how much you’ll need to retire. I’ve never seen him have the patience to fill one of these out and they only take two minutes to complete! The solution is what author Robert Sheard calls the Twenty Factor Model.

Basically the formula is:

Financial independence = annual income requirement X 20

The formula is based on two centuries of returns in the market and the actual rate of return (5% per year) you can expect to earn after taxes, fees and inflation.

If you have 20 times your required annual income, that means with a fixed withdrawal rate of 5% per year from your nest egg and a net annual return on your investments of 5%, you will never run out of money.

Now isn’t it much easier to increase your 20 income than filling out one of those online calculators? I thought so. Let’s go.

5. Insurance Method:

You should have a policy worth at least five to eight times your annual income.

Some planners recommend five to eight times your annual income as the level of cover you should carry. My suggestion is to get your financial house in order, which means getting your net worth and cash flow together, and go talk to a good insurance agent about your needs.

He will be able to guide you through the various options. As with a financial planner, ask them how they are compensated to keep them honest with the advice they give you.

Please note that this factor or rule can be very high, depending on the number of years of income you will have to transfer. The highest “factor” I’ve seen is to multiply your annual after-tax income by 20.

Interestingly, it is the same rule as above. There is no coincidence here. If you die and want to make sure your dependents will receive exactly what you brought home each month, they need to replace your income completely forever. According to the Twenty Factor Model, having an insurance policy worth at least 20 times your annual income will do.

6. Method of Charity:

Pay at least 10% of your net salary every month.

Most of us think that there is not enough money to go around. We live in a state of scarcity instead of abundance. We think that if we pay ten percent of our income every year, we can’t afford it or we can’t afford to retire.

I understand the fears, but if you follow the previous five rules of thumb, you shouldn’t have to worry too much about making ends meet. Let me explain.

Journalist Scott Burns, in his article titled, “A Look Back,” analyzed how much money you’d need to save to be penniless when we die, assuming we’re 65. retired. The result was that we would have to save 34 percent of our income if we planned to live another 20 years after we retire. The analysis assumed that we would not get a return on our investments.

But you will earn something on your investments, right? Of course you will. Burns goes on to show that the higher the return on investment, the less you will save.

The 34 percent of income that young people would have to save today if they earned no return would drop to 25 percent if they earned a historically real 2 percent return.

If he earns a 5 percent real return with a 60/40 stock/bond portfolio, that drops to 15 percent.

If they earn a 7 percent real return on common stocks, that drops to 9 percent of earnings.

You’re already putting 10% of your money aside (Pay Yourself First) and once you pay off your short-term debts, you’ll have 20% of your savings free to invest wisely. In fact, if you put money aside for tax arrears, you put aside 10% of your net income every pay period, but why split hairs.

In short, you have more than you think.

Give it a try and see how little it will affect your standard of living. You will definitely feel better about yourself and you will help others in the process. No wonder it’s my favorite rule.

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